US Economic Ballistics

Now that the dust has settled somewhat from Taper-mania, it probably makes sense to take a step back and reassess the US macro landscape over a longer time frame.

The market consensus seems to be that everything will be fine. Consensus equity forecasts remain fairly bullish. Expectations for GDP growth the rest of the year hasn’t really budged. In fact, since 10y Treasury yields began moving higher in early May, 3Q growth expectations have actually ticked higher. (Q2 expectations have fallen, but appears to have been driven by yesterday’s weak retail sales figure rather than anticipated effects of higher rates)



A simple gut check, however, suggests that it is too early to signal the all clear. First, the pace of the move was substantial. On a 3 month basis, nominal yields moved over 90bps, which puts this recent episode as amongst the 6 worst periods for Treasuries over the past 20 years. (Chart below shows 10y nominal yields and the rolling 3m change in the bottom panel. Note that with the exception of 1994, all those episodes resulted in a stabilization in yields over the subsequent months)



As some of our astute readers have noted, these types of moves have historically had a significant impact on interest rate sensitive sectors such as homebuilding. The chart below highlights this, as well as the fact that this recent episode is essentially on par with the 1994 experience, albeit the pace is much faster this time. Note that we express the mortgage rate in percentage terms, since a $100 / month increase in mortgage payments is a much bigger deal if the original payments were $800 as compared to $1600.



There are, however, a number of offsetting factors that mitigates these worries. Homebuilding remains a smaller driver of US growth than in the past. The ratio of debt service payments to income are at multi decade lows. And the current mortgage rate of ~4.5%, remains BELOW the 4.74% to existing mortgages, unlike the prior instances when yields jumped.



However, TMM notes that personal expenditures growth has exceeded real income growth for some time – and TMM suspects that the refinancing activity was likely a key driver. I.e. even though real income growth has been broadly flat since 2009, (first chart below, bottom panel) consumers have been able to refinance their mortgages with a ~5% rate to ~3.5% and used to cash flow for consumption, which has grown at a fairly steady rate of 2% YoY in real terms. (Second chart below, bottom panel) If true, this tail wind is likely to weaken.





As a result, TMM thinks that a continuation of recent growth trends will require a successful growth handoff. The improving employment picture is a positive, but TMM thinks that ultimately, improvements in real wage growth will be needed. That could happen on its own as the unemployment rate continues to decline – i.e. the US economy may have already achieved ‘escape velocity,’ albeit at a slower pace than historically. However, the jury is certainly still out on this. The San Francisco Federal Reserve, for example, recently noted that the reluctance of employees to accept wage reductions meant that there may be a substantial amount of “pent up” wage reductions that are getting reduced via frozen wages that are gradually eroded away by inflation. The authors calculated that the number of people with frozen wages remains a substantial portion of the labor force:
http://www.frbsf.org/economic-research/publications/economic-letter/2013/july/wages-unemployment-rate/

On net, the balance of risks for consensus growth expectations after the recent move appears to be on the downside. This suggests US yields are likely to stabilize around current levels, at least for a while. Equity prices, however, are likely to be less affected, even if there is a slowdown. The chart below shows SPX performance in the months following historical yield spikes of comparable magnitude. All instances showed positive returns 5 months later.



As a result, equities we expect to carry on gently into outer space. (new highs)

Meanwhile something unexpected may happen to the Dollar. There is a strong belief, certainly positionally, that the USD is on a steady ride upwards too, but if we look at USD performances during the events above (BoE’s USD index used below) we see that it has actually come off:



So in the case of the dollar there is a fair chance that it may well not make it into orbit and fall down to earth.

In summary, here is a modern artistic representation of TMM’s views on US Equities, Treasury Yields, and the USD:


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Leftback
admin
July 16, 2013 at 2:50 PM ×

Very nice summation.

Hard to short US equities at the moment, but there are certain sectors (as discussed) that will surely underperform after the yield spike, and the recent rise in gasoline prices will also impact consumer discretionary spending in Q3.

Excellent point on USD. Once the media start banging on about King Dollar and actually noticing it has been strong, it is almost certainly time for the Buck to decline. Likewise, the media are slamming China and other BRICs on a daily basis after they have been eviscerated this summer by dollar shorts covering. Time to buy?

With this in mind, LB would like to propose a theme for the 2nd half of '13, namely: "EMs over DMs". With China and India in the dumpster, and Russian and Brazilian equities trading at multiples <5 while many US growth stocks trade at >1000, it's not a difficult argument to make to the value guys. If they still exist.....

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abee crombie
admin
July 16, 2013 at 4:51 PM ×

Nice post. Small sample size on the tightening effect so I would be a little cautious. Would rather go with logic and intuition but that doesnt mean I am bearish of stocks.

One does have to wonder about the growth handoff, SPX earnings growth and implied equity valuations.

The recent run up since Nov has been all about multiple expansion. Partly due on the back of "lower for longer" which is no longer valid. (at least on LT rates which should be the discounting rate looked at for equities). That doenst mean equities have to go down, but without increasing earnings growth, what is going to justify this market going higher. I see more of a grind up, but you never know. To the moon is possible.

At the real economy level I am more bullish. Wages are slowly growing (but not at the same speed for all employees) and the fiscal drag will wear off and growth should bounce back to 3% in 14. But its hardly robust.

Also I dont get the explosion in tech. Dont they have the most overseas exposure and isnt that where growth is weakest. anyways

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Leftback
admin
July 16, 2013 at 5:11 PM ×

Abee, I know we disagree but I still think it is too early to say whether the statement below is really going to hold true.

"Partly due on the back of "lower for longer" which is no longer valid."

A couple of p*ss weak US jobs numbers and a sub 1.0% GDP print, and the market's take on FOMC monetary policy and rates at the long end might change very quickly. There are also going to be at least some earnings disappointments ahead, and the transports (UPS, FED EX etc) have already give notice on where those might be.

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GMS
admin
July 16, 2013 at 6:49 PM ×

Hi Abee,
You're right, the sample size is pretty small. Normally we wouldn't include it, but the 6 for 6 hit rate after 5 months for equities, and after 3 months for the dollar seemed worth noting.

And fully agreed on multiple expansion being the driver. As you say, it started in November... right when Real Yields bottomed! So the question is if those are related, and if so, whether the relationship will continue. Hard to say, but it's an interesting hypothesis to follow for now.

LB, well noted on a potential 2H theme. There does appear to be plenty of cheap assets in EM space. As they say, pick your poison!

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Anonymous
admin
July 16, 2013 at 7:22 PM ×

C says
From sunny Spain may I say I said it in far fewer words "wake me up when wage increases become real". For the moment I think we still top on equities regardless with our recent rally simply a very nice squeeze very symptomatic of such a range. That also being reinforced by LB and probably others still finding a buy in what they think is the latest underperforming areas. That is ,if you buy emerging you would probably also be buying say FTSE miners for the same reason. At this point I have swung the portfolio to be once again slightly to the short side overall.

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Gnome of Zurich
admin
July 16, 2013 at 9:06 PM ×

EM over DM may be, especially now that Greece has become an EM. My bet for the 2nd half is on the most hated PIGS. Takes not much for positive surprises there.

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Anonymous
admin
July 17, 2013 at 9:55 PM ×

there's one argument against drawing any conclusions based on the sample besides the sample being too small: the current yield spike is a reaction to expectations regarding the abnormal fed policy, i.e. it may not reflect any changes in inflation and/or growth expectations, whereas previous spikes may have been normal in that they were driven by changes in inflation/growth expectations

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long time lurker
admin
July 18, 2013 at 10:58 AM ×

@ anon 9:55
I agree 100% , you articulate it well

very expensive 4 words "this time it's different" but those prior periods were likely presaged by declining equities, rather than those inflated by QEx

the shift out of bons is symptomatic of a great front running trade unwinding, like many things the fed has distorted, I think this is just merely one of them

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July 20, 2013 at 6:32 PM ×

This article is mind blowing. When I read this article, I enjoyed.

book publicity

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